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BookingAlpha Option Trading Advisory

Wednesday, April 4, 2012

Locking profits with the Box Spread

The Box Spread is a strategy where two vertical spreads (one using calls and one using puts) with opposite bias are entered in the same strike prices.

For example, On March the 9, you could have bought an SPY April 138/140 Bull Call Spread  for 0.94 debit. And at the same time the 140/138 Bear Put Spread for a debit of 1.06.

Each position neutralizes each other. The total debit invested is 2.00, but there is no risk in the overall position because the losses in one spread will be neutralized by the gains in the other spread.

BUY 138/140 Bull Call Spread @0.94
BUY 140/138 Bear Put Spread @1.06

(Click on image to enlarge)
Notice the horizontal red line (which depicts profits/losses by expiration) is positioned right on the zero line, for the whole spectrum of SPY prices. So, there's in fact no risk in this position, and no possible profit either. It would be in fact dumb to play something like this as you would only be feeding your broker with commissions.

Now, why isn't there a profit? and how can a profit be obtained out of something like this?
The reason there is no possible profit is that the combined cost of the spreads 1.06 and 0.94 = 2.00 equals the width of the spread, 140-138 = 2.00 points. In fact if the pricing of options were always perfect this would always be the case: the sum of contrary spreads would equal the width of the spread.

However, sometimes this is not the case. If the combined cost of the opposite spreads is less than 2.00, on spreads like these of 2.00 range, then there is an arbitrage opportunity! Where risk free money can be made.

Let's say you could buy the 138/140 Bull Call Spread for 0.94 and the 140/138 Bear Put spread for 1.01 instead of the 1.06 it cost on March 9. In that case you would be entering the 2 point wide Box Spread for a total debit of only 1.95 and that results in a guaranteed profit of 0.05, or $5 per contract played.

BUY 138/140 Bull Call Spread @0.94
BUY 140/138 Bear Put Spread @1.01

(Click on image to enlarge)

There is now a guaranteed profit of $5 throughout the whole spectrum of possible SPY prices. The position doesn't need to be closed, you just open it with the guaranteed profit and let it get to expiration.

Exploiting this price inefficiency in reality is difficult, first you need an options friendly broker with very low commissions, as the arbitrage opportunity won't offer more than a few dollars per contract. And second, and this is the main factor, there are many computerized algorithms scanning for arbitrage opportunities like this one every second. If the price inefficiency shows up, algorithms immediately exploit it, which makes the pricing schema adjust itself to normal after a few seconds. This makes the window of opportunity very small for this type of arbitrage to be manually exploited by people.

How can you still benefit from the Box Spread?
Maybe you can't really exploit the Box Spread for opening risk free positions, due to the two factors mentioned above. But knowing the principle that make it work, you can apply that principle in other situations. You can for example lock in profits in existing positions where it is hard to exit due to liquidity issues.

The principle is simple:
The combined cost of two opposite spreads is usually equal to the width of the spreads. If this combined cost is less than the width of the spreads, there is an opportunity to lock in profits.

Let's analyze the first example where I purchase a 138/140 March Bull Call Spread for 0.94. The opposite 140/138 Bear Put Spread is worth 1.06, but I don't purchase that one. I only enter the 138/140 Bull Call spread betting that the market is going up.

BUY 138/140 Bull Call Spread @0.94

A few days later the market has moved up (in my favor) and the 138/140 Bull Call Spread is now worth 1.20. Obviously at this point, the 140/138 Bear Put spread must be trading at 0.80. If at this point I purchase the  140/138 Bear Put spread for 0.80, I would be locking the box with a guaranteed profit.

BUY 140/138 Bear Put Spread @0.80

I have invested 0.94 + 0.80 = 1.74 in a Box Spread that is 2.00 point wide, therefore I have a difference of 0.26 in my favor. The trade will now return $26 per contract at expiration and it is risk free, and there is no need to close anything, just let the whole box expire and save the commissions. There is no way to lose in this position. There is a 0.26 guaranteed profit.

Instead of creating the Box Spread, the trader could have simply sold his Bull Call Spread, which he bought at 0.94 and was trading at 1.20, and the trader would have obtained the same 0.26 profit per contract. That is true, however closing the original position becomes hard in some cases due to liquidity issues. Instruments like SPX, RUT, might be very difficult to close at times due to this reason. But, if you detect that there is more volume in the strike prices of the opposite spread or more open interest, you can decide to create the Box Spread, your fill will be easier and the Box Spread will have the same profit locking effect as if you had closed your original position.

Related Articles:
How to lock in profits on an options trade and stay in the position
Locking profits on a Vertical Spread
The Three Legged Box explained

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  1. Feels wonderful having this article learn lot.

  2. In theory sound good, but is it possible can get this kind of opportunity ? any scanner available for this strategy in the market ?

  3. It's worth nothing that if you had entered the first spread with 50 days to expiration and 2 days later you create the box, you will have locked in the profit, but you will have to wait 48 days to expiration keeping your money stuck in the box while if you can exit the trade you will be able to reload that money and potentially make new profitable trades. I would only do this when either there are only a few days to expiration or I'm not going to use the margin for another trade.

    1. You are correct Dani and that's one of the disadvantages of locking the box. Thanks for pointing it out.

  4. Okay - right now, there is a short box on Sep SPY calls for a $10 spread - 205/215. The bid/ask is 10.44/10.64.
    Isn't that a guaranteed profit of almost .50? Since it's a short box, you are taking money in, so there's no capital tied up. Why does this trade exist? Shouldn't the machines erase it?
    Where is the risk? What am I missing?
    Right now, the market is HEAVILY betting on the downside - IVs are 13% for below the stock price and 8% above it.

    1. The machines should take care of it quickly, or your commissions won't make this a viable strategy. These arbitrage opportunities are usually for the high frequency algorithms and large pools of money to make it worth it and usually with better commission schemas.

  5. That's not the case here, though. It's something else. I opened one of these trades just to see - sold a $10 short box for $10.48. With a $4.60 commission, that's a profit of $43.40 - on money taken in, not on debit. The only downside I see is getting early assignment, but why wouldn't the algos take that trade? It's 10% profit in a month - more for them because they pay almost no trade fees.
    Not getting something, but only dipping a toe in the water to see how it plays out.

  6. if you use /ES (emini options) you will see lot of oportunities with a very low cost (commission and fees)
    I've been doing this strategy for a week now: buying a box (i put a limit order) and wait to be filled.
    Once i got filled, i put a new sell limit order (with some cents above, being sure to cover commissions and kee some profit) and also worked.!!
    So within minutes, I'm making very good returns

    Now, this is made on my paper account... not sure how much this could change on real. That's why i'm doing more research on this.
    Anyone could explain?

    BTW: i'm using thinkorswim platform.

    1. To tell you the truth I haven't done it in a real money account.
      Haven't even tried. But that is the ultimate proof of concept.
      Some things happen on paper money that simply don't in real money.
      I would expect box spread opportunities to be heavily monitored by High Frequency algorithms.

    2. who will be the first to test this on real account :)
      I'm just checking that everything is taking in account... commissions, fees, etc
      I know that there would be potential risks if you left the position until expiration.. like early excersice or assignments... but what i'm doing is buy the box and sell it within minutes, 1 hour top